Preparing for negative rates

July 5 (Reuters) – If you are not prepared for negative
interest rates, you may have left it too late.

The European Central Bank on Thursday cut interest rates by
25 basis points to a record low 0.75 percent, and ECB chief
Mario Draghi acknowledged afterward that actual negative
interest rates are part of his arsenal.

Following suit shortly thereafter the Danish central bank
cuts its own rates by 25 basis points, a move that took a
secondary certificate of deposit rate to -0.20 percent. That’s
right, some Danish savers will now be paying their central bank
for the privilege of lending it money.

While many “real” interest rates – the rate taking into
account inflation – have been negative for some time, investors
are increasingly finding themselves faced with securities which,
however safe, are essentially pay-to-hold.

This is far from being unprecedented. Germany already allows
investors to bid negative yields for short-term government debt
at auctions. In January, the Treasury Borrowing Advisory
Committee, a group of Wall Street bond market participants,
urged the U.S. Treasury to do the same.

In short, global interest rates are low and show every sign
of grinding lower, perhaps even into negative territory.

The reasons why are as obvious as they are complicated.
Europe is a mess and is sending waves of deflation globally as
its weaker states struggle to regain competitiveness. This will
either go on for a long time or end suddenly: with a huge burst
of deflationary power if the currency area breaks apart.

China’s bubble looks to be deflating, and the U.S. is in the
midst of a very long process of paying back debt and cutting
risk.

That this should be happening at the same time as some
borrowers are being punished with very high rates of interest is
not surprising. Spanish 10-year bond yields climbed to 6.78
percent after the ECB decision, rising by their most in a single
trading session for almost 20 years.

That was partly because markets hoped the ECB would do even
more to ease economic pain, but also for the very simple reason
that, left as it is on its own, Spain (and many other borrowers)
are very bad bets.

So rising rates for some are a symptom of the same
underlying ill – debt deflation. Many borrowers can’t pay, and
will default, and almost worse, many who can repay will, further
stifling the debt-fuelled growth we enjoyed up to 2008.

WHAT THEN TO DO?

Traditionally, very low rates should be a boon to equities.
Low rates, as central bankers intend, encourage people to sell
bonds and take on more risk for higher returns. Low rates also
make today’s value of future earnings theoretically higher,
something that many believe should drive an expansion of equity
price/earnings multiples.

So far, neither of these drivers appear to be working.
Investors continue to fear equities and flock to bonds, despite
record low yields in safe instruments. And as for rising P/Es,
corporate profits are at record highs in the U.S., but investors
seem more concerned about how they will be sustained than what
they are worth relative to very low Treasury yields.

That’s correct. There is no free lunch in investing, and
record low yields are only a feature because we are in
extraordinarily difficult economic times.

Conversely, these should be the worst of times for bonds,
with seemingly extremely asymmetric risks. After all, even if
you see rates going negative that simply can’t be a sustained
state.

At a certain point central banks will react to deflation by
printing enough money to make it stop. That is going to –
eventually – play havoc with bond returns.

Still, the best way to look at low bond yields is to
understand that the cost of safety is high because the value of
safety is high.

Which, as always, brings us to the vexed question of gold.

Gold has had a bad year, and a standard explanation would be
that its buyers are less concerned with inflation, or less
confident in central banks’ commitment and ability to fight it.

Gold does, however, offer a kind of option value, protecting
people who are worried that their home currency will be debased
with a crude but sometimes valuable kind of insurance.

As ever, over-confidence is often deadly, and anyone who
believes they understand with a high degree of certainty how
this will work out is almost certainly deluded.

Hedge your bets, and be willing to pay up for keeping your
options open.

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